During the last election, the American public heard a lot of tough talk regarding a rising China. This talk came from both sides of the aisle. Although the rhetoric and policy prescriptions varied depending on who was speaking, everyone seemed to agree that China had become a dangerous rival, if not an outright threat.
One talking point that seemed to grip the public, in particular, was that China owned billions (now trillions) in US debt. This narrative played off the prevailing anxiety that the US was getting weaker as rivals grew stronger in a bid to dethrone America as the world’s only superpower.
It’s easy to see why the US’s debt to China played right into these kinds of fears. On the surface, the facts of the situation do sound alarming. Our fastest-growing global rival could hold billions, even trillions of dollars of debt over our nation’s head. That sounds like an unequivocally bad situation to most people.
However, this alarmist narrative is at best misleading and at worst dangerous. That framing of the situation skews the way that debt owed between countries actually works. People who pushed that narrative were either woefully misinformed or trying to score a few easy political points.
Don’t let yourself fall prey to this kind of fear mongering. Below, we’ll break down how the US-China debt situation actually functions, whom it benefits, and whether you should be worried about it.
What Sovereign Debt Isn’t
Before we dive into the details of China and the US debt, let’s try a simple thought experiment.
You are eight years old. You want to buy a new toy at the store, and you want it NOW! Unfortunately, your allowance this week isn’t going to cover it. In desperation, you turn to your older brother and ask him to front you the money for the toy. He agrees, as long as you agree to pay back the loan with interest.
You agree and you get your toy. Over the next few weeks, as you’re paying back the loan, your brother becomes increasingly demanding. He forces you to clean his room and do his chores. If you refuse, he says, he’ll take your toy back to the store, return it, and get his money back. Meanwhile, interest on your loan starts to pile up; you begin to wonder if you’ll ever be able to afford to pay it off.
The above scenario is a little bit cutesy (and a little bit cynical), but that’s how many people tend to think about debt. On an individual level, debt is a useful tool for getting something that we want but can’t afford, at least not right now. However, it can become a burden. That burden can give a creditor a large amount of power.
Here’s the thing: the US/China debt scenario is almost nothing like that. Our everyday experience with debt is different from the realities of sovereign debt.
Why do countries buy up sovereign debt?
Countries buy up US debt for a few basic reasons: to build up foreign exchanges, peg their currencies, and store value (notice that a desire for coercion is missing).
Most countries that trade globally buy up sovereign debt on a regular basis because doing so allows them to participate in the global market while exerting some control over their own markets and currencies. These “foreign reserves” help pay for goods and investments in foreign countries, and they help keep banking systems stable. In other words, countries buy US dollars so they can spend them.
Buying up debt also allows countries to “peg” their currencies to the US dollar. In essence, “pegging” a currency means tying that currency’s exchange rate to another, more stable country’s currency. Doing so stabilizes the pegged currency, making it more predictable. In addition, when a country pegs its currency to another currency, it can exert more control over the strength of its own currency.
Finally, countries buy up sovereign debt because it is a low-risk way to store value. US debt is in especially high demand because the United States, despite what its detractors might say, is one of the world’s most stable countries. That fact makes the dollar a strong and predictable currency. When you buy US debt, you are sure to get value out of it.
Overall, countries buy sovereign debt because it makes good economic sense. Sovereign debt provides countries with a predictable mechanism for participating in the global economy, stabilizing its own currencies, and storing value over the long term. It doesn’t buy sovereign debt to manipulate rivals.
It’s worth noting, by the way, that the majority of US debt is actually held domestically. While the US debt is more than $19 trillion, the government, especially Social Security, owns only about $5 trillion. Businesses and individuals own another $8 trillion or so. Foreign governments own about $6 trillion, which is an enormous number, but it’s still less than one-third of the total debt.
Why does China own so much US debt?
We’ve covered the reasons that countries tend to buy sovereign debt, but why does China seem to have such a large appetite for US debt in particular?
For the majority of the last decade, China has been the most significant foreign holder of US debt. It briefly lost the top spot to Japan in 2016, but regained it earlier this year. As of July 2017, China owned $1.10 trillion in US debt, a number that is likely to grow as time goes on.
China, along with many other Asian nations, developed an appetite for US debt at the end of the 20th century, when the 1997 Asian financial crisis destabilized economies across the continent. Seeking to stabilize their economies, many Asian nations invested heavily in US Treasuries for the reasons discussed above.
Past that, China realized that the key to keeping up its rapid growth was keeping its currency weak in relation to the dollar.
China relies heavily on exports to the United States to finance its growth. In order to keep these exports plentiful and affordable for the enormous US market, China must keep the yuan relatively weak. On its own, the value of the yuan would rise, causing Chinese exports to rise in price which would undermine China’s position in the market. China keeps the yuan weak in part by buying up US debt, which in turn inflates the value of the dollar, to which its currency is pegged.
The result is that Chinese products remain cheap, and Chinese investment capital continues to flow into the US. This arrangement could not continue if China didn’t buy up US debt.
In short, more than trying to control the US, China is trying to control its own currency and financial future by buying US debt.
Is it good or bad that China owns so much US debt?
Oddly, it might actually be good for China to keep buying up US debt, at least in the immediate future.
When China buys US debt, it’s actually strengthening the dollar by buying US Treasuries. Buying US debt, after all, is not an opportunistic move. If anything, it’s a statement of belief in the long-term strength and stability of the dollar.
In addition, China actively seeks to weaken the yuan by buying US debt. If you’re convinced that China is the US’s mortal enemy and that whatever is good for China is bad for us, then this might be kind of a mixed bag. While a weak currency doesn’t sound like a good thing, a weak yuan definitely benefits China in the immediate by allowing it to flood the market with cheap exports. The average American individual definitely benefits, though, by getting access to incredibly cheap goods and services.
Overall, China owning US debt helps to perpetuate a relationship where the dollar’s value stays inflated but Chinese imports to the US are cheaper and more affordable. In return, China continues to stabilize its currency and stay competitive in the huge US market. At least in the short term, this situation seems to shake out to a win-win.
What if China called in its debt?
Let’s flashback to our analogy from earlier with the older brother. To recap, you took out a loan from your older brother to buy a toy. Ever since, he’s made your life miserable as you try to scrape together the money to pay him back.
One day, he comes into your room with an ultimatum: he needs his money back, now. He doesn’t care how he gets it. He starts collecting all your valuables, including your new toy, to resell to recoup his investment. You try to protest, but to no avail.
This analogy is essentially the kind of doomsday scenario that some people try to conjure up when discussing China and the US debt. What if China decides to throw its weight around? If we owe it that much money, doesn’t it own us? In other words, what do we do if China decides to “call in” its debts?
